Overview of Project Finance Risk
Project finance risk is considerable. However, project finance is the financing method which is best suited for managing, allocating and mitigating risks.
Responsibility for dealing with risk in project finance falls squarely on the project finance provider. Global Trade Funding has unparalleled expertise underwriting project financings to assess, allocate and mitigate the risk. We employ innovative sources and methods of project financing, and use a broad array of risk management tools to assess, manage and mitigate project finance risk. We utilize every tool in the box including complex deal structure, innovative uses of project documents, locally connected contractors and operators and anything else we need to protect our clients.
Allocating Project Finance Risk
Just as important as identifying and assessing project finance risk is allocating those risks to the project participants or stakeholders who are best suited to manage the risks. Thus, allocating project finance risk is one of the most effective and cost effective forms of risk mitigation.
If stakeholders are responsible for project risks they are not suited to manage, the entire project finance structure is at risk. Therefore, the crux of every project financing is the proper allocation of risk. It is also often the most difficult part of a project financing. The most significant characteristic of project finance is the art of minimizing and apportioning risk among the various participants and stakeholders.
How are the risks in a project financings allocated? The principal instruments for allocating the risks and rewards of a project financing are the voluminous project finance documents, specifically the contracts that are created between the project company and other stakeholders. While often the most time consuming and expensive documents to create, efficient risk allocation is essential for making projects financeable and critical for maximizing performance.
Mitigating Project Finance Risk
Risk Mitigation
Lenders mitigate credit risk in a number of ways, including:
• Risk-based pricing – Lenders may charge a higher interest rate to borrowers who are more likely to default, a practice called risk-based pricing. Lenders consider factors relating to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit spread).
• Covenants – Lenders may write stipulations on the borrower, called covenants, into loan agreements, such as:
o Periodically report its financial condition,
o Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary actions that negatively affect the company’s financial position, and
o Repay the loan in full, at the lender’s request, in certain events such as changes in the borrower’s debt-to-equity ratio or interest coverage ratio.
• Credit insurance and credit derivatives – Lenders and bond holders may hedge their credit risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk from the lender to the seller (insurer) in exchange for payment. The most common credit derivative is the credit default swap.
• Tightening – Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers. For example, a distributor selling its products to a troubled retailer may attempt to lessen credit risk by reducing payment terms from net 30 to net 15.
• Diversification – Lenders to a small number of borrowers (or kinds of borrower) face a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.
• Deposit insurance – Governments may establish deposit insurance to guarantee bank deposits in the event of insolvency and to encourage consumers to hold their savings in the banking system instead of in cash.
Get Financing For Your Project Today
Unparalleled underwriting expertise uniquely positions us to identify financing obstacles and improve deal structure to minimize risk and attract lenders. Then we present an optimized loan package to our worldwide network of lenders and investors resulting in project finance with the best terms and least risk in the industry.
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